Ideoblog

The persistent fiduciary duty minefield in LLCs

Francis Pileggi notes Delaware VC Parsons' recent decision in Kelly v. Blum, in which the court denied a motion to dismiss plaintiff's claims that managers and controlling members breached their fiduciary duties by willfully engaging in a self-dealing squeeze-out merger. The case deals with three frequently-litigated issues in Delaware in connection with an LLC merger – the derivative-direct distinction, applying fiduciary duty opt-outs in LLC operating agreements, the scope of members' fiduciary duties, and the meaning and scope of good faith in the LLC context.

The case illustrates that despite all of the fiduciary litigation that has washed under the bridge or over the dam in Delaware, there are still lots of buried mines (not to mix metaphors or anything).

Derivative-direct distinction. The fiduciary duty issues typically begin with the angels-on-a-pin question of whether the claim is derivative or direct. The plaintiff here complains among other things about self-dealing in connection with a merger of the LLC in which the plaintiff was an owner. Since the plaintiff was validly merged out of the LLC he lacked standing to bring a derivative suit on its behalf. (Speaking of angels, in order to reach that conclusion, the court had to find that written consents to do the merger were valid, which arguably involved the question of whether Good Friday is a "business day." I'll leave that issue for a later day.)

The court found breach of a fiduciary duty owed to plaintiff individually, thereby providing the basis for a direct action. Although this decision is unremarkable under prior law, I question the need to go through these entity-based derivative-direct contortions in an LLC in my Litigating in LLCs article.

Opting out of fiduciary duties. In order to determine whether the complaint stated a cause of action for breach of fiduciary duty, the court had to apply the fiduciary duty provisions in the agreement. The court first held, unremarkably, that the mere fact that the agreement did not explicitly provide for a duty of loyalty did not prevent application of default duties.

The court then had to consider whether the agreement limited the application of these default duties. The agreement provided:

[t]he Board of Managers shall manage the affairs of the Company in a prudent and businesslike manner and shall devote such time to the Company affairs as they shall, in their discretion exercised in good faith, determine is reasonably necessary for the conduct of such affairs.

And

[i]n carrying out their duties hereunder, the Managers shall not be liable for money damages for breach of fiduciary duty to the Company nor to any Member for their good faith actions or failure to act ... but only for their own willful or fraudulent misconduct or willful breach of their contractual or fiduciary duties under this Agreement.

The court found no exculpation in the first provision. The second provision permitted monetary damages for willful breach of duties, which the court found in the allegations that the managers "actually and specifically intended to extinguish Kelly's membership interest in Marconi, knowing that such action would harm Kelly."

This interpretation is sensible. But one wonders in what circumstances a breach of fiduciary duty would not be "willful," and therefore exactly what this provision in the agreement was intended to accomplish.

In general, the Delaware courts' approach of requiring explicit drafting regarding fiduciary duties continues to give the parties fits. I don't blame the courts, but wonder why the lawyers can't seem to make the language clearer. See my analysis of contracting for fiduciary duties in The Uncorporation and Corporate Indeterminacy, and a possible explanation in terms of lawyers' failure to develop research and development concerning contract clause, discussed in my Death of Big Law.

Controlling members' duties. The court held that the complaint alleged a breach of fiduciary duty not only by LLC managers but by controlling members. The court reasoned that "fiduciary duties include the duty 'not to cause the corporation to effect a transaction that would benefit the fiduciary at the expense of the minority stockholders.'" (quoting Gentile v. Rossette, 906 A. 2d at 103).

Although there is language in the case supporting this result, it is inconsistent with the nature of fiduciary duties. As I've argued in my Are Partners Fiduciaries? fiduciary duties should, and generally do, exist only where there is open-ended delegation of power to managers, not in the exercise of contracted-for voting power by members, as in this case.

Good faith. Although the court upheld fiduciary duty allegations, the court dismissed the claim for breach of the implied contractual covenant of good faith because the plaintiff had not adequately alleged breach of the obligation, how he was damaged or any obligation to seek alternatives to the merger. Moreover, the LLC agreement explicitly permitted the company to enter into self-interested transactions.

This logical conclusion renders even more questionable the court's willingness to allow the fiduciary duty claim against the controlling members. Indeed, it points up the basic problem of imposing fiduciary duty liability on members who are exercising their voting rights under the agreement, as argued in my article linked above.

In general, this case illustrates that despite the broad contractual freedom allowed LLCs under Delaware law, fiduciary duties are still a minefield, particularly in merger transactions like the one in this case.

Silicon Valley and the uncorporation

Writing in today's Wall Street Journal, Tom Perkins notes that "too often, there is confusion between investment banking and venture capital." In fact, they are "very different." That's because:

We earn our reward only when companies become successful. Investment bankers are deal makers. * * * Their money is earned by the transaction, and in the fraction of the time it takes a venture capitalist to realize a profit. Whereas Wall Street has been the source of what feels like endless scandals and financial catastrophes, venture capital has created jobs, jobs, and more jobs of the highest caliber.

Perkins explains how VC has managed this:

[W]e set up our partnerships to avoid specifically problematic practices. These parameters included: no leverage; audited statements; never investing personal capital where the partnership could or should do so (that is, no "cherry picking" at the investors expense); no profit participation until the investor's entire capital had been repaid; limited partnership life and no investments of new capital in older deals. These early ideas have become nearly universal over the decades. And in my opinion, they have kept our industry healthy, profitable and largely scandal-free.

Perkins is referring to the essential features of the uncorporation – flexibility, strong-form incentives, and the absence of corporate-style capital lock-in. For more detail, see Chapter 8 of my Rise of the Uncorporation, and particularly pages 226-28.

Nevertheless, as Perkins points out:

Venture capital is constantly at risk of being swept up in federal tax and regulatory initiatives aimed at curbing Wall Street's abuses. Last year our industry was originally included in new SEC rules aimed at hedge funds and other sources of systemic risk. But the managers of venture capital firms, usually partnerships, are not risking capital raised from the general public or guaranteed by the federal government. They are not financial advisers in any sense of the term. But the default mode in Washington is to regulate broadly, without regard for unintended consequences.

Part of the problem, as I warned on p. 241 of my book, is that "uncorporations have had to swim against the tide of legal efforts to channel firms, particularly large firms, into the corporate form." Hopefully Congress ultimately will see, as Perkins argues, that uncorporations are not the problem but part of the solution.

The SEC continues its war on the shorts

The SEC, by a 3-2 vote, has adopted its "uptick" rule (201) restricting short selling for stocks moving more than 10% down in a day unless the stock price is above the current national best bid. The Commission's release quoted Chairman Mary Schapiro as saying

[t]he rule is designed to preserve investor confidence and promote market efficiency, recognizing short selling can potentially have both a beneficial and a harmful impact on the market. It is important for the Commission and the markets to have in place a measure that creates certainty about how trading restrictions will operate during periods of stress and volatility.

Opponents beg to differ, per the WSJ:

"The unintended consequence of this rule will be an erosion of confidence at a critical time when the economic recovery is struggling to take hold," said James Chanos, a frequent short seller who is chairman of the Coalition of Private Investment Companies.

"The lack of the uptick rule had nothing to do with the market collapse in 2008—it was bad policies all around that created that disaster," said Bill Fleckenstein, who ran a short-only hedge fund until he closed it in early 2009. "It's more monkeying with the system and doing things that address issues that have nothing to do with the underlying problem."

Although the rule doesn't touch routine shorting by hedge funds and others based on perceptions of whether stocks are over-valued, it can reduce market efficiency at the most critical times when uncertainty pervades the market and stocks are trying to find their appropriate level.

Here's what I said when this issue emerged a year ago in the midst of the financial meltdown:

As I've argued, "short-sellers are significant potential contributors to market efficiency." Here and here is some evidence. Here's my and Bruce Kobayashi's extended argument in favor of efficiency-driving trading by informed outsiders, and my analysis of the arbitrage function of short-selling in disciplining "noisy" markets.

Hardly anybody -- particularly politicians -- likes to see markets gyrate the way they have been, particularly not when the gyration is mostly down.  But markets need to stabilize and rise the old fashioned way -- based on information. Removing a significant mechanism supporting market efficiency is the last thing we need in these times. 

Finally, consider this:  the securities markets are a report card on government actions.  These actions, as I've said, are undermining and destabilizing markets by, among other things, dithering and threatening property rights. So it's not surprising that Barney Frank -- a key architect of the housing bubble that got us into the mess -- would like the naysayers to go away.

Corporate shareholders vs. people

Todd Henderson has a great post about this line he read in a Roger Cohen article in the New York Times:

When it comes to health it makes sense to involve government, which is accountable to the people, rather than corporations, which are accountable to shareholders.

To which Todd responds, in part:

Shareholders are people. Who exactly does Mr. Cohen think owns our corporations? We do. The "people" who allegedly can hold our government to account are exactly the same people who can hold our corporations to account. If corporations are not accountable to us, the fault dear Brutus lies not in the stars but in ourselves.

Neither the government nor corporations are perfectly accountable or aligned with the people's interests. The question is which is more capable and accountable under specific circumstances. Markets for labor, capital, and products and services provide discipline for firms; elections provide discipline for government. Sometimes we can rely on the former — no one believes we would have a better Internet search engine, grocery store, or computer if it were provided by Uncle Sam instead of Google, Whole Foods, or Apple. Sometimes we can rely on the latter — no one believes we could reduce acid rain without government involvement, in one way or another. There is a reasonable debate to be had about how well functioning the market for delivering health care is and how we may be able to improve it, but that debate is not advanced at all by absurd claims like Mr. Cohen's. We law professors tinker at the edges to try to make governments and corporations more accountable, but to flatly assert one always dominates the other is just sophistry.

Does Mr. Cohen really think the government is always accountable to the people? Let me guess that Mr. Cohen was opposed to the invasion of Iraq. Who exactly does he think did this? Hint: it wasn't a corporation.

The misconceptions Todd discusses are at the heart of the criticism of the Supreme Court's recent Citizens United case, as discussed in my analyses of the case here and in this debate.

Executive compensation of law deans

Via Tax Prof (and many other sources linked there) comes news of former Maryland Law dean Karen Rothenberg's almost $800,000 compensation for 2007. This reportedly included $350k for an untaken sabbatical approved by the university president, and $60k for summer research grants reportedly approved by a subordinate.

A Maryland faculty member writes in the Baltimore Sun that

Dean Rothenberg was poised to move on to higher opportunities. But, we at the law school and at all levels of the university wanted desperately to hold on to her as dean for another few years. * * * The retention package she received, totaling $410,000, was significantly less than she deserved and could have obtained had she chosen to bargain hard with the university. As to the budget categories used for the payments, universities tend not to have a discreet budget category titled "keeping your best people." Consequently, university presidents and deans who wish to retain their top talent draw the funds from existing compensation categories, such as sabbaticals, research grants, stipends and special funds.

This business about "budget categories" sounds so darn technical we shouldn't worry about it as long as Dean Rothenberg was worth every penny, right? And certainly this is true for Dean Rothenberg, about whom a colleague opined:

When I think of Karen as Dean, the first word that comes to my mind is "principled." In all the tough decisions that we had to make, she would always ask "what is the principled thing to do? * * * Karen was also an excellent steward of law school resources, never wanting to spend unnecessarily even at the expense of her own comfort.

This was nothing like executive compensation, is it? I hope not, because we wouldn't want to treat a law dean like a plain old corporate executive – like, say, Brocade CEO Greg Reyes, who is facing a retrial after his initial backdating conviction was reversed. Mr. Reyes was valuable to his company but slipped up on an accounting issue.

I'm not directly familiar with the Rothenberg facts and have no idea whether any laws were violated in this affair. Surely building a company that sells a product and is accountable to shareholders is nothing like being a law dean and being accountable to a university president or maybe a subordinate. So I wouldn't want to get carried away with this analogy.

Businesses as movie good guys

Lisa Fairfax says that at a conference on "Corporate Governance and the Vision of the Firm" "one person noted that he could not think of a movie that portrayed business in a good light." Erik Gerding responds with some examples.

Erik and Lisa need to read my article Wall Street & Vine in which I discuss three categories of films that are not about evil capitalists: "employees in charge," "socially responsible management," and "the businessman as artist." Specific examples of films that in one or more of these categories are Jerry Maguire, Charley Varrick, the Godfather films, Do the Right Thing, Sometimes a Great Notion, Schindler's List, Heaven Can Wait, Two Weeks Notice, That Certain Thing, It's a Wonderful Life, Mr. Deeds Goes to Town, Executive Suite, Iron Man, Batman Begins, The Dark Knight, Citizen Kane, The Magnificent Ambersons, Tucker: The Man and His Dream, The Bad and the Beautiful, Jurassic Park, and The Aviator.

Want to know more about how I categorize these and a lot of other films? Want to know why, as Erik asks, it's "so hard to find a movie that celebrates large corporations square-on?" Read the article!

Bankruptcy phobia

David Skeel argues persuasively that this underlies some questionable decisions in the recent financial crisis and historically. Here's the abstract:

As the recent economic crisis has unfolded, bankruptcy has offered possible solutions at several key junctures. The first of these solutions, often referred to as mortgage modification, was geared toward homeowners who faced the loss of their homes in the months - now several years - since the start of the subprime crisis. On the corporate side, Chapter 11 was an obvious alternative when large nonbank financial institutions like Bear Stearns and AIG stumbled in 2008. But regulators repeatedly balked, and the one exception to the avoidance of bankruptcy at all costs - Lehman Brothers - was anomalous. This aversion to bankruptcy, which seems to pervade all sides of the political spectrum, is the bankruptcy phobia that I explore in this Essay. I begin by speculating in more detail about the reasons for resisting bankruptcy-based solutions. The second and third parts of the Essay will then put the recent crisis in historical perspective. While the absence of bankruptcy solutions and new bankruptcy reforms at the outset of the crisis was puzzling, the historical analysis suggests that it is consistent with the pattern of previous crises. Using the late nineteenth century and the Great Depression as my principal examples, I will argue that significant bankruptcy reform, in striking contrast to major corporate reform, has often come well after a financial crisis was underway, and that the proliferation of dramatically different proposed bankruptcy and nonbankruptcy solutions that we see today is also consistent with historical patterns. I will conclude by speculating about some of the implications for bankruptcy reform.

God, gambling and stocks

Here's Kumar, Page and Spalt, Religious Beliefs, Gambling Attitudes, and Financial Market Outcomes:

We use religious background as a proxy for gambling propensity and investigate whether geographical variation in religion-induced gambling norms affects aggregate market outcomes. We examine four economic settings in which the recent literature has suggested a role for gambling and speculation. Our key conjecture is that gambling propensity would be stronger in regions with higher concentration of Catholics relative to Protestants. Consistent with our conjecture, we find that religion-induced gambling preferences influence the portfolio decisions of institutional investors. Investors located in regions with high Catholic-Protestant ratio (CPRATIO) exhibit a stronger propensity to hold stocks with lottery features. Further, in a corporate setting, we show that broad-based employee stock option plans, which are likely to appeal more to employees with stronger gambling preferences, are more popular in high CPRATIO regions. Examining the aggregate impact of gambling on stock returns, we find that the initial day return following an initial public offering is higher for firms located in high CPRATIO regions where local speculative demand is expected to be stronger. In a broader market setting, we find that the magnitude of the negative lottery-stock premium is larger in high CPRATIO regions. Collectively, our results indicate that religious beliefs, through their influence on gambling attitudes, impact investors' portfolio choices, corporate decisions, and stock returns.

I'm a bit dubious about these results, but go read the paper.

More on Citizens United

The Federalist Society's online debate on the Supreme Court's recent corporate speech decision, in which I'm participating, continues with some interesting speculation on, among other things, the speech rights of associations generally.

More praise for Rise of the Uncorporation

Steve Davidoff's article discussed in my previous post also contains some nice words about my most recent book:

My mention of Professor Ribstein above leads me to note that I recently finished his latest book, "The Rise of the Uncorporation." The book is a theoretical analysis of "uncorporations," which are, as he puts it, "general and limited partnerships and limited liability companies and other noncorporations that are the principal organizing vehicles for private companies." This book is likely to set the framework for the analysis and development of the law governing these entities. I heartily recommend it to anyone looking to understand the boom in these alternative corporate entities and its implications for corporate law.

If you're one of the holdouts who hasn't yet gotten this book, rush to correct your mistake.